Two basic assumptions underlying the market approach to health care reform are that the health care market can be, in some way, modified to enhance price-elasticity of demand for health services offered by individual providers and that this price-elastic demand would induce price competition among providers. There are two ways to increase elasticity of demand. One way is to make individual consumers more cost- conscious shoppers. The other way is to authorize payers to selectively contract with providers offering high-quality, economical care. One example of the latter is the California-type payer-driven competition reform. Payer-driven competition may make the demand even more price elastic because payers are more capable of using information and are more powerful in negotiating price discounts with providers. The major objective of study is to test whether the pressures created by California selective contracting programs (which supposedly increase the elasticity of demand for hospital services) are associated with lower hospital costs, based on California hospital data from 1987 to 1992. The pressures, referred to a managed care pressures in this study, are composed of three sources of market forces affecting individual hospitals: the competitive pressures from peer hospitals, the pressures from market penetration of managed care payers (e.g., HMOs, PPOs and Medi-Cal), and the pressures derived from the volume of services hospitals offer to each managed care payers. This study will also try to identify the factors affecting hospital cost variation by investigating changes in productivity, hospital-physician relationships, and hospital service structure. Further, hospital profitability under managed care pressures will be addressed. Findings of this study will shed a light on provider performance under price competition. For example, this study may help policy makers and administrators understand where competition fails to reduce costs or adversely affects hospital financial health to the point that government interventions are needed to assure efficient distribution of health resources.